November 30, 2021

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Investing in Corporate Bonds: A Risk You Should Be Aware of

Investing in Corporate Bonds: A Risk You Should Be Aware of

When investing, risk is defined as the variability of the return on invested capital over time. Investing in German government bonds is considered a risk-free investment, because the regular profitability that supports it and the repayment of the principal on the maturity date is normal.

Now let us consider the profitability that a company gets from the capital invested in its company. In this case, profitability (or loss) is uncertain and volatile. Therefore, the shareholders of the company consider it a risky investment. For this reason, it is important for a business, aware that the capital associated with its business is subject to potential losses, to know the importance of diversifying a portion of its personal assets into other types of assets, such as real estate, a retirement plan or a liquidity cushion. It’s easy but how do I achieve it? One possibility is to bring other shareholders into the company to reduce the amount of personal capital and reduce the risk of total assets.

There are a number of entrepreneurs who, bent on remaining the majority shareholder, have limited their company’s growth and exposed their aging and personal assets to a high risk of lack of diversification. And although this strategy sometimes generates enormous wealth, in most cases the opposite is true.

Entrepreneurs take risks because of economic drivers: to get rich (or create value). Value is created when the company’s profitability exceeds the opportunity cost, which is the profitability that can be achieved with alternative investments of similar risk and duration. In this sense, the alternative costs are determined by the internal risks of the company in question, which are divided into operational risks as well as financing risks.

Business related or operational risks
Operational risk or financial leverage is defined as the volatility of operating profit due to fluctuations in sales. If the company’s sales increase by 10% and the operating margin (profit divided by sales) is maintained, this means that all operating costs will also increase by 10%. However, fixed costs do not change in the short run, so an increase or decrease in sales often has a greater impact on profits.

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As sales fluctuate from period to period, fixed costs cause fluctuation (leverage) in operating margin. On the contrary, frequent sales protect the community from this potential effect.

To better understand this idea, we will explain the breaking point which sets the minimum sales needed for operating profit to be zero.
We see in the graph that the level of fixed costs is independent of sales and the variable costs directly associated with them. By combining fixed and variable costs, we get total expenses. The point at which sales overlap with total costs is the tipping point.

Below the equilibrium point, society loses because it spends more than it earns. But once it passes, it brings benefits if sales continue to grow, as Mara does, because fixed expenses are maintained. This is called the positive leverage effect. However, this applies to a number of activities, because fixed expenses (warehousing, personnel …) move in blocks. Companies with low operating margins and high fixed costs, cyclical fluctuations or sales uncertainty have extremely high operational risks. Therefore, before continuing to grow, they must develop alternative strategies to reduce it, and it is important to know:

  • Repeated order level (only repeat order reduces risk),
  • cost structure,
  • balance point,
  • operating margin.

Knowledge of this data will enable entrepreneurs to make a rational decision and implement an informed model for managing the operational risks of the company.
Converting fixed costs into variable costs reduces risk. There will also be business strategies that drive loyalty and prove sales, such as the subscription-based business model, as long as they don’t disrupt profit margins. If the profitability of the investment offsets the expected risk, then reducing the risk justifies a lower return.

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Risks arising from indebtedness as a source of financing
You face the risks arising from the use of financial debt as a source of financing. Financial risk is defined as the variance in profit before tax due to fixed interest expense.

When the debt is used to finance a business, the contractual fixed financial cost (interest) is covered by operating profit and the principal is repaid according to the agreed schedule. Thus, in debt financing, the company displays a certain profit for the additional fluctuations of the company, which is assumed to be at the level of operating profit, since the interest costs will not adjust to its fluctuations.

investment

Financial risk depends on the ratio between the financial debt and the capital invested by the company. The greater the weight of the debt, the greater the leverage and thus the risk. So it is the cost of the debt or the rate of interest on it. Interest is a fixed expense that is required to cover even if sales and operating profit decline or the company incurs a loss. The higher the cost of debt, the higher the risk to the company. There is also financial risk in balancing cash flow generation over time and principal repayment dates. If the company is financed for several periods by short-term debt, it is exposed to constant renegotiation and possible changes in circumstances by its financial creditor.

Companies with lower operating risk may accept higher financing risk because they have a higher and/or fixed operating margin. On the contrary, companies with low operating margin, periodic sales and a high share of fixed costs in the total volume should be very careful when using debt.

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Any business, operational or financial decision that puts future cash flows at risk is a risk because the future is uncertain.

growth management
Another key aspect of running a company is growth. In order to grow, new financial resources must be spent, which may come from the pocket of the private entrepreneur, other shareholders or banks. However, before the injection of new capital, its effect on:

  • merchandise growth rate,
  • an increase in fixed costs,
  • operating margin,
  • The possibility of higher indebtedness.

It is not appropriate to grow by attaching new capital, increasing risk and reducing profitability. If growth helps companies reach or at least approach a tipping point, improve profit margins or take advantage of inaction without increasing financial risk beyond what is appropriate, then in most cases the decision will be valuable.

Moreover, growth at any cost does not add value when it grows at the cost of increasing risk and reducing profitability below opportunity costs.
Finally, another consideration: Extraordinary profits are made only by those who take risks and embark on a journey into the unknown and uncertain. And the attitude to investment icon Warren Buffett’s question: “Risk comes from not knowing what you’re doing.”